EU hits banks with CDS investigation

OPACITY:The EU is cracking down on what an analyst says is an opaque method of transaction in which nobody knows the worth of anything until it is too late

Reuters, BRUSSELS

The US$28 trillion credit default swaps market came under investigation on Friday by the EU, adding to official pressures bearing down on a huge and opaque business that is widely blamed for aggravating the recent banking and eurozone debt crises.

The European Commission, the EU’s executive body, said it is probing whether major investment banks, including Goldman Sachs and JP Morgan, colluded in their operations in a market that is already under scrutiny by US authorities and being subjected to broad, new regulations.

Credit default swaps, or CDS, are derivatives that let a buyer transfer loan default risk to a seller, making them a kind of insurance against default. CDS can also be bought by speculators without direct interest in the debts involved.

CDS played a central role in the near collapse of American Insurance Group Inc in 2008, which led to a massive US taxpayer bailout of the former insurance giant. The contracts have also been at the heart of the debt crisis engulfing some weaker EU states.

The EU probe comes as the 27-nation bloc struggles, along with the US, to complete a government crackdown under way for months now on the broad, US$600 trillion off-exchange derivatives markets, including CDS.

“CDS play a useful role for financial markets and for the economy,” said the EU’s anti-trust commissioner, Joaquin Almunia, in a statement announcing the two-track inquiry.

“Recent developments have shown, however, that the trading of this asset class suffers a number of inefficiencies that cannot be solved through regulation alone,” he said.

Almunia added that a lack of transparency could lead to abusive behavior and that he hoped the probe would improve financial markets and aid economic recovery.

PREVIOUS PROBE

The US Department of Justice in 2009 launched an inquiry into anti-competitive practices in the trading, clearing and pricing of CDS in the US. A spokeswoman for the department declined to comment on the EU move.

Unlike other derivatives, such as grain or metal futures, credit derivatives are risk transfers.

“It’s a banking function that’s been converted by this small group of banks into a trading instrument,” said Karen Shaw-Petrou, managing director at consulting firm Federal Financial Analytics.

“The problem is no one knows what anything is worth unless or until the entity against which the CDS is placed defaults ... That’s what makes it very opaque,” she said.

In Europe, CDS moved to center stage last year as Greece grappled with higher borrowing costs, blaming the move on speculators raising default insurance costs.

The European Commission, which regulates competition in the EU, said it would investigate whether 16 investment banks had colluded or abused a dominant market position.

BOOKKEEPING

The opaque CDS market, where industry players say the only record of some multimillion-euro deals is just a fax, has frustrated politicians who have struggled to understand it because there are few central records of trading.

“It is not a transparent market,” Shaw-Petrou said. “It’s a liquid market ... but there’s no real proof of value other than moment-to-moment exchanges that are then impossible to verify because it’s not a public exchange.”

The probe could hit banks’ bottom lines as the EU can fine companies up to 10 percent of revenues and has handed out penalties as big as 1 billion euros (US$1.5 billion).